Participants in loan modification programs pawn their futures. Overextended borrowers overpay for their cost of housing and promise any future equity to a lender for the privilege of continuing to use and overpay for the family home.

The 3rd term that can modified is the principal, although under the conditions of HARP and HAMP, the principal may be foreborne, that is, the principal can be reduced for the period of the loan, but must be paid back when the house is sold, or foreclosed on, or borrowed on. … It changes a non-recourse portion of the loan into recourse.

Today, I want to explore the implications of loan forbearance with principal deferment. I recently found a great post at Housing Kaboom with a relevant anecdote for today’s discussion:

… It just amazes me how many people really do beleive prices are going to shoot right back up again. They are convinced the bubble prices were normal and that the current price point is the aberration.

The second conversation was with a person a friend introduced to me to talk about his loan mod. I’m no financial guru but I still get asked for advice. I tell em my advice is free and worth every penny!

On the surface this loan mod sounded golden. Their current loan was for for roughly $600k, an Option Arm of course. They also had a heloc for $100k that they used to pay bills, buy a car and put a back yard in (so it’s all gone). They have not made a payment on the heloc in 2 years. He works in a distribution center driving a forklift, his wife is a admin assist (whatever that is). Together they make$84k (seems like a lot for those jobs but that’s what he told me they made). BTW, the house is worth approx $280k, he thinks.

The original loan was a option ARM and of course they are making the min payment of $1800/mo, the payment on the heloc was $1200 but since they are not paying it I guess it doesn’t matter. The only other debt payment they have is a $400/mo car payment.

Check out this loan mod offer. He gets a 25yr fixed with a payment roughly equal to his $1800/mo (before taxes). His taxes are $480/mo. So his total nut is $2280/mo or roughly 32% of his gross. Here’s the kicker though, in order to make that happen they stuck a $420k forbearance on to the end of the loan (balance of the original loan, plus the reverse arm amount, plus fees and late payments). He’s happy as a pig in shit. I’ve never seen a mod like this one and it’s from some lender I’ve never heard of. I’m wondering if this mod is a one in a million or if they are offering up mods like this on a regular basis. If this is common then this crisis will drag on for decades as these folks default when they need to move.

I asked about what he will do if he needs or wants to move. “Oh, that will not be a problem, prices will have recovered in a few years and we will be fine”. WHAT?? Are you freeking kidding me. You think a tract home in So. Corona on a postage stamps sized lot will be worth $700k in a few years. His new total loan amount is for $100k more than peak prices AND he still owes the heloc. He is trapped in a cave of debt and the foreclosure monster is just waiting for him to pop his head out.

Ponder for a moment what loan forbearance with principal deferment accomplishes;

The principal is immediately increased. For those hoping appreciation will save them, this act raises the bar appreciation must hurdle.

Negative Amortization adds to principal. During the temporary payment period — which the people in the example above will treat as permanent — the shortfall for interest is either added to principal or directly subsidized by US taxpayers.

The larger principal amount increases interest payments. At some point the interest rate subsidies will end, and borrowers will be forced to make fully amortized payments on a debt they could never afford. The exploding Option ARM is embedded into the loan modification agreement.

In short, no homeowner is going to see a dime in equity in their lifetime, and only their false hopes keep them paying on the loan.

I discussed the implications of this kind of lending solution back in April of 2007 in How Homedebtors Could Avoid Foreclosure. Let’s review some of the highlights:

There is no way to effectively restructure payments when a borrower cannot even afford to pay the interest on the debt. Lenders cannot lower interest rates to near zero because then they will lose money on the loan. Any borrower who thinks the lender is actually going to forgive the debt and allow them to keep their home is really living in a fantasy world (I would wager many FBs believe this). Lenders will not take a loss on a property loan and allow borrowers to keep the home: it’s as simple as that.

As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don’t pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.

Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let’s further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.

The structure I outlined is a little different than the government’s loan modification program, but the impact is substantially the same. People get so far underwater appreciation cannot save them. In the end they sell for a profit and give it to the bank.

Sounds like a panacea, doesn’t it? There are some problems.

The first problem will become apparent when people start selling their houses. People are greedy. They won’t want to give the bank all their equity when they sell. They will conveniently forget the debt relief and avoiding foreclosure and all the problems they had earlier. All they will see is that they sold the house for a lot more than they paid for it, and they did not make any money. And what happens when the appreciation does not match the term of the note? Do they do a short-sale 20 years down the line? This will cause a huge uproar and more calls for congressional intervention. In other words, for everyone involved the day of reckoning is merely delayed, not avoided.

Was amend-extend-pretend really a surprise to anyone? Isn’t denial and delay the always the first and most easily predicted policy response?

Second, it does nothing for the affordability problem. If prices do not crash, a great many people really will be priced out forever. To solve this problem, banks will make zero coupon bonds available to everyone, and eventually everyone will have them. Think about where we will be then: we will be a society of homedebtors who have collectively agreed to give all our equity to the bank for the pride of ownership. Starts to sound a bit like Pottersvillefrom It’s a Wonderful Life. Is that the way we all want to live?

Isn’t signing up an entire generation for debt slavery really what lending is about? Lending already increases house prices well beyond their all-cash value, if they added zero-coupon juice to prices they could inflate them to such a degree that only those who sign up for their lifelong debt structures can afford them.

Once lenders have (1) maximized current debt-to-income ratios that drain borrower’s current cashflow and (2) issued every market participant enormous zero coupon notes that later capture all resale appreciation, lenders will have buttoned up the system and drained every resource possible from the housing market. At that point, owners will have fully converted to lifelong money renters.

Third, The zero coupon bond solution would effectively eliminate the move-up market because you won’t have any equity to take with you from house to house. Unless you save money or get a big raise so you can afford a larger payment, you can’t buy a more expensive home. This would result in a dramatic flattening of prices. In other words, the low end would be supported at inflated levels while the high end would stagnate or decline.

Fourth, Based on the problems above, it will be difficult to find a new equilibrium in prices. How would people figure out how much anything is worth? How would all price ranges be supported equally? Small changes in the interest rate on the zero coupon bond can make the difference between hundreds of thousands of dollars at the time of sale, particularly on a long-term hold. Does anyone think this will turn out in favor of the borrower? I suspect we would see a lot of short-sales as the banks graciously agree to take all the gains and forgive the rest of the debt. This takes us back to our first problem with angry, greedy sellers.

Finally, I think this is only a short to medium term solution to the foreclosure problem. For as much as we are addicted to credit in this country, there is a point where people will say “enough is enough.” When a house fails to have any investment value, people will not be so excited about home ownership. People can blather on about pride of ownership all they want, but people want to make money on selling their houses. Inflated valuations are only supported by greed. If home ownership becomes less desirable, prices will end up falling back to their rental equivalent value because the demand will not be there. In the long run, we would end up with prices where they should be anyway, it would just be a much more prolonged and painful journey.

My views have not substantially changed in the three years since I wrote the above. The circumstances are what they are, and to the extent loan modifications with principal deferment occurs is the degree to which we will have the problems outlined.